Style drift happens when an active manager
drifts from a specific style, asset class, or index that is
described as the investment purpose of a portfolio or mutual
fund. For example, a manager may drift from small cap value
to small cap growth. This is a substantial problem if you
have carefully determined your Risk Capacity™ and matched
it to a Risk Exposure.
Hypothetically, you may be intentionally
invested in a growth fund. Then unbeknownst to you, your active
manager takes 30% of your Large Cap Stock fund and puts it
in cash and bonds. This changes your growth fund to a balanced
fund, changing the risk exposure, return, and time horizon
of your investment.
To avoid style drift, it is best to implement
your asset allocation with "pure style" index funds.
Index funds are invested using clearly defined rules of ownership.
Forty percent of the time, actively managed funds follow a
manager's drift to a market that the manager thinks will keep
his shareholders happy and save his own hide. Unfortunately,
the shareholders suffer in the long run. As we have seen in
previous steps, this predicting or chasing of returns has
resulted in "below market" performance.
" Style
drift is a serious problem for [investors] because
it distorts asset allocation and undermines
performance when styles rotate. Value managers
who have drifted over the past three years [1998-2000]
toward more favored growth stocks are regretting
those moves, but not as much as their [investors].
"
Ron Surz, President,
PPCA Inc., Get the Drift, 2001
''
If a fund is drifting to a style that is dramatically
different, your potential returns, volatility, and
risk are going to change.''
Rosanne Pane, Director,
S&P Fund Services Group, Spotting 'Style
Creep', When a fund starts
to wander, returns can suffer, BusinessWeek
Online
" One
thing is clear: Style drift happens to a sizable
percentage of mutual funds...For [investors
or] planners seeking to create portfolios tapping
into consistently different equity styles, style
drift presents a significant concern."
" The
SEC deems it a fraud if performance results
are compared to an inappropriate index, without
disclosing the material differences between
the index and the accounts under management.
"
Robert J. Zutz, "Compliance Review", Schwab Institutional,
Vol 10, Issue 8, Aug., 2001 [IFA comment:
Any investment different from the appropriate
index will get different returns. Technically
speaking, the comparison of any active manager
to any index is inappropriate, due to style
drift]
Investment
professionals and academics use many terms to define
risk. These include markets, benchmarks, asset classes,
styles, style boxes, investment objectives, risk factors,
market dimensions, market segments, buckets of stocks,
rules of ownership, slices of the market, industry
classifications, and indexes such as Dow Jones Indexes,
Standard and Poor's Indexes, Russell Indexes, Wilshire
Indexes, Morgan Stanley Capital Indexes, Wired Index,
and many more. Style is just one of many terms used.
It is simply a classification of an investment's risk
characteristics. Investments can be grouped into several
criteria or dimensions.
Stocks of a particular style generally share long-term
risk, return, and correlation characteristics. This
helps investors and financial planners decide how
to allocate their assets. An equity fund's style refers
to the types of stocks the fund holds.
Active mutual fund managers define their own investment
style, which guides them in picking individual stocks.
For example, a fund manager may manage a growth fund
that reflects a style preference of growth stocks.
The problem with investment style is that it is not
consistently defined within the industry. Terms such
as large, small, value, and growth have a wide range
of definitions. This lack of specificity makes it
difficult for investors to measure their risks and
rewards, and easier for active managers to claim market
beating returns over a nebulous benchmark.
A growth style includes stocks that are experiencing
rapid growth in earnings, sales, or return on equity.
Growth stocks tend to carry low book-to-market ratios,
high price earnings ratios, and usually offer no dividend
yields. Growth stocks are priced much higher than
their book values, indicating a large portion of the
purchase price goes to goodwill. Goodwill is basically
the difference between the price and the book value.
Growth is somewhat of a misnomer. The price paid for
goodwill is often deflated by news of lower than expected
earnings growth of these companies. Growth stocks
are expected to underperform value stocks and the
total market.
A value style includes stocks that tend to carry high
book-to-market ratios, low price earnings ratios,
high dividend yields, and are often described as being
in distress. They are thus perceived by investors
to be of higher risk, but investors need to remember
that higher risk equates to higher expected return.
The shareholders of value stocks have a high cost
of capital, which equates to a higher expected return
for the capital provider. The capital provider is
the investor, or the capitalist. Value stocks may
receive a lot of negative publicity and experience
a downturn in their business.
The styles of large, small, and micro are based on
a company's share price multiplied by the total number
of shares. Companies are ranked and grouped into categories
that vary substantially within the investment industry.
For example, as of September 2001, the Russell 2000
index of small cap stocks had a weighted average market
cap of $800 million, while the DFA small cap index
had $600 million, and the DFA Micro cap index had
$250 million. Morningstar, Russell, Lippers, Barra,
Wilshire Associates, DFA, Morgan Stanley Capital Indexes,
and Standard and Poor's are all considered reliable
sources of style criteria. Each has its own set of
rules for measuring value, growth, large, small, international,
or emerging markets. It is no surprise that the active
investor is dazed and confused.
Style drift refers to the tendency
of active managers and actively managed mutual funds
to deviate from their stated or expected investment
style. This drift can occur gradually over time, as
in the case of a "small-cap" manager buying larger
and larger companies as their fund asset base grows.
Style drift can also occur abruptly if an active manager
perceives opportunities for higher returns from a
different style. For example, a U.S. large company
fund may purchase a high percentage of Mexican stocks,
changing the fund's style.
